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I posited at the beginning of this correction that shorting volatility looked very enticing at current levels. That has turned out to be a terrible call as my belief that there would be a quick rebound in the equity markets was disproved. I’ll provide my outlook for the markets and shorting volatility going forward from here. Ever since the current market rout started, I’ve been salivating at the chance to get short volatility via the short term volatility ETF VXX (NYSEARCA: VXX ). This is a strategy I’ve used repeatedly over the past year or so to take advantage of buying the dip on a leveraged basis and it has worked very well. Unfortunately for me (and many others) this dip turned into a correction. My last post on the subject seems like ages ago at this point but if you’d like to see my rationale at the time, please take a look. Some time has passed and the landscape for shorting volatility has become a lot more complicated so in this article, I’ll update my views on shorting volatility and see what I think is next for markets and VXX. (click to enlarge) Obviously, I was too early. That comes from my steadfast belief in “buy the dip” that has developed over the past six years of this bull market. It has worked beautifully in the past but of course, this time it did not. This is why it is important to keep volatility-related positions small and why I always issue that warning in VXX pieces. I’ll issue it again here and offer that any position in VXX is, by its nature, speculative. Please keep positions small and understand that the potential for large rewards comes with the potential for sizable risks as well; the chart above shows this better than my words can convey. Now that we’ve established my original premise for shorting volatility this time around has proven to be unequivocally incorrect, let’s take a look at what may happen in the short to intermediate time frames with respect to the market and the VXX. The fact that the VIX is still elevated above 23 this many weeks into the correction is something I never thought would happen as it was beginning back in late August. I saw the spike down as just that and nothing more but obviously, we have something larger on our hands here. (click to enlarge) The VIX is showing tremendous ability to remain elevated and given the term structure at present, it appears traders think it will continue or even go higher. Credit: VIX Central We can see the spot VIX is near 24 while the front month is just over 22. But if we look further out, there is only a small drop in what the market is predicting volatility will look like several months into the future. While this isn’t unusual during a correction, there is real money on the line here so there are some traders with serious firepower betting on a sustainably higher VIX. The second mistake I made is in assuming contango would disappear quickly, as it had during so many quick down turns in the market in the last several years. As you can see, I made a pretty high probability bet that the spike in contango would be short-lived. Obviously, that is not the case. While contango has lessened significantly, it is still present. And as the down turn in 2011 showed us, it can stay that way for a long time. Given the way the VIX is behaving so many weeks into the spike, I have to think we are in for some more suffering before things get materially better. Now, these two conditions were the very reasons I originally put my short VXX trade so I’m not going against my system that has worked time and again; what I’m saying is that this time is different and requires a different approach. I found out this time was different the hard way – by losing money – but that doesn’t mean we can’t adapt and learn. First, I think the equity markets are in for some more selling before repairs can be made to the damage that we’ve seen in the past six weeks or so. We can see here that when the market (NYSEARCA: SPY ) broke down, it broke down hard and hasn’t looked back. (click to enlarge) The spike bottom has yet to be retested and the SPY formed a rising wedge pattern in the midst of a down trend, usually a bearish formation. We can see the formation was broken in the last week or so and stocks have moved down ever since. I think this wedge pattern coming to completion and the fact that there are no catalysts to buy mean a retest of ~187 on SPY is very likely and perhaps, even a move lower than that. The bottom line is my short to intermediate term outlook on the SPY is negative until we get a retest of the spike lows and until that happens VXX’s bias is up, not down. While the basic conditions of my short VXX trade are still in place (contango, elevated VIX) the one other major condition (a healthy stock market) has disappeared. That means VXX, VIX, and contango could stay elevated for extended periods of time and that means the short volatility trade is probably going to tread water or see another move lower in the coming weeks. I moved out of my short VXX position for a sizable loss because conditions changed and my reasoning for the trade in the first place evaporated. While taking losses is very painful, it is the right thing to do when you are proven wrong by the market. I will short VXX again at some point but I need to see a few things first. I need to see the SPY retest its lows successfully. That will mean a move down from current levels and some painful selling to set up a base that currently does not exist. Until that happens, shorting VXX is very dangerous. Second, I need to see the VIX sustain selling pressure. Until the market retests its lows the VIX is likely to stay elevated. That means shorting volatility in general isn’t going to work. Lastly, I think time is the final condition. This correction has taken a psychological toll on investors and that takes time to heal. Extremely volatile action like we’ve seen causes people to bail and until calm is restored, sustained buying pressure – and lower volatility – are going to be hard to come by. The time will come to short VXX again will come but for now, I’m out of this trade. I was proven wrong by the market so I’m licking my wounds until a better opportunity presents itself. Scalper1 News
Scalper1 News